At its core, diversification is deliberate uncertainty recognizing that it is difficult to know with particular subset of an asset class, or sector is likely to outperform another. Broad diversification, done effectively, seeks to capture the returns of different types of investments over time but with less volatility at any one time. Diversification done right should produce long term returns that outperform portfolios that are too heavily weighted in any one security, sector, or asset class. However, there are four vital keys to effective diversification that must be understood and effectively applied to ensure long term success:
Risk and Returns are Related
For long term investment performance, it is the deliberate assumption of risk that drives returns. The more risk you are willing to assume, the greater the returns you should expect. Portfolio diversification is the primary tool for managing risk so that it is not concentrated in any one investment; rather, it is spread among different asset classes, which can reduce portfolio volatility and produce more stable returns over the long term.
The key to effective diversification is recognizing that different assets and all of the subsets of assets have varying ranges and patterns of volatility. For instance, equities as a whole are less volatile than any one subset of equities. It is through the higher volatility of some subsets of assets and the exposure to different patterns of volatility that higher returns are possible without increasing the standard deviation, or risk of your overall portfolio.
Asset Mix is Critical to Long Term Investment Returns
Central to any investment strategy, regardless of an investor’s risk comfort level, is the long-term mix of assets. Based primarily on the premise that not all assets move in concert, and some are more volatile than others, the purpose of asset allocation is to capture the benefits of diversification while investing in assets that have a low correlation to each other. The practice of asset allocation seeks to achieve the optimum mix of assets that will generate returns linked directly to your long-term investment objectives. Because of the fundamental economic relationship between risk and return, to an overwhelming degree, an investor’s selection of asset mix has the primary impact on that investor’s long-term investment returns.
It’s Not True Diversification if it’s not Global
In essence, you expose your portfolio to more volatility and risk when you invest solely in the U.S. markets, and you certainly miss the opportunities for the returns that are available in the global markets. In any given year, foreign markets and their subsets of emerging economy markets, developed countries, and the various regional markets (i.e., Asia, Europe, South America, etc.), will perform contrary to one another and/or to the United States. Because it’s too difficult to identify which markets will outperform or fade, global diversification enables your portfolio to capture returns wherever they occur.
Mutual fund managers are under tremendous pressure to outperform the indexes and show their investors that they are investing in “the winners.” This is why the vast majority of growth mutual funds own many of the same stocks. For example, Apple, which is one of the best performing stocks of the last five years, is a top holding in 45 percent of growth stock mutual funds. So, if you own four or five different growth stock mutual funds, chances are you have a great deal of exposure to Apple stock or any number of the more heavily traded stocks at the moment.
Since it is impossible to reliably identify winners before the fact, the most prudent approach is to maintain broad diversification and consistent exposure within various asset classes. When your portfolio is properly diversified it can capture returns whenever and wherever they occur while managing the risk-return tradeoff according to your risk profile. Because your portfolio values change, it would be important to review your portfolio annually to ensure it is maintaining the optimum level of diversification for your investment needs.
*This content is developed from sources believed to be providing accurate information. The information provided is not written or intended as tax or legal advice and may not be relied on for purposes of avoiding any Federal tax penalties. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel. Neither the information presented nor any opinion expressed constitutes a representation by us of a specific investment or the purchase or sale of any securities. Asset allocation and diversification do not ensure a profit or protect against loss in declining markets. This material was developed and produced by Advisor Websites to provide information on a topic that may be of interest. Copyright 2014-2015 Advisor Websites.